Bond Portfolios Down Year to Date | Stock Talk Podcast
Unprecedented Moves:
Do you have losses in your bond holdings? Bond markets have declined in unison with stocks year to date primarily for one reason. The Federal Reserve has moved with historically large and fast interest rate hikes. They’ve done it at one of the fastest paces in 100 years. This after being overly easy from a monetary standpoint for years.
I’ll say it. The Fed’s moves in 2022 have been unprecedented for the last 50 years. Only Alan Greenspan in 1994 comes close when he doubled rates in 12 months.
See it for yourself: Given Septembers CPI, these increases should continue in November and December. Ugh.
So far, 2022 has been almost as bad for bond investors as for stockholders. Many in the financial press like to focus their stories on the “sexier” assets like equities or private technology companies instead of talking about bonds and fixed income. These stories get more clicks and views than talking about boring bonds most of the time.
Hell, up until this year, most bond managers on TV would spend more time talking about bitcoin, gold, or stocks than their own bond portfolios. 2022 has been a trainwreck for most bond portfolios.
I am Chris Perras with Oak Harvest Financial Group in Houston, Texas and welcome to our weekly stock talk podcast, keeping you connected to your money. Before we get into this week’s topic, “Why are my bond portfolios down so much this year?” Please take a moment to click on the subscribe button and click on the notification bell so you will be alerted when our team uploads our latest content.
We’ve talked about bonds and fixed income a couple of times over the last few years. Only 18 months ago, many investors we spoke with were worried that their fixed-income portfolios were yielding so little. We saw many prospective clients searching for higher yields in their portfolios, wanting to buy more risky credits or lengthening their maturities in an attempt to gain another quarter percent to 1% in yield.
Once again, stretching for income yield in the public markets has turned out to be a very bad strategy.
A quick refresher. In simple terms, a bond is a loan from you, the investor, to a borrower. The borrower can be the US Government if you are buying Treasury securities or maybe a municipal government or a corporation. The borrower uses the money to fund its operations, or their own capital investments and the investor receives interest on the investment and their principal back at some future date. Unlike owning equities, a bond is a contractual obligation.
Two points of note. First, the best outcome the owner of the bond can have is they get their interest coupon over time and secondly when the bond matures, they get their money back. That’s the best outcome. Your money back and a little cash along the way. That’s the contract.
However, secondly, and this is what many retail bondholders forget, is that the market value of a bond can, and usually does, change over time throughout its maturity length.
I’m going to keep this as simple as possible. There are generally 2 types of major risks in owning bonds. The first is the issuers creditworthiness. Basically, how likely is the borrower to give you your money back at the end of the term of the bond? When the bond matures. When the contract expires. This is credit risk.
The US Government is thought to be the gold standard in credit ranking. Why? there is little to no risk that the US government won’t pay back their debts. They can always print more money. On the other side of the spectrum are junk bonds and emerging credit markets.
These are homes to the extremes of higher-risk borrowers that can have big trouble paying off their debt when the economy slows, or the economy goes into a recession.
The second major risk to bonds, that many investors are experiencing for the first time in decades, is interest rate risk. Remember there is an inverse relationship between interest rates and bond prices. As interest rates fall, bond prices rise.
- Conversely, when interest rates rise, bond prices tend to fall. Many advisors correctly describe this dynamic as a teeter-totter or see-saw.
Why does this happen? Because when interest rates are declining, investors try to lock in the highest rates they can for as long as they can. To do this, they will buy bonds that pay a higher interest rate than the prevailing market rate. This increase in demand translates into an increase in bond prices and lower yields.
- On the other side, if interest rates are rising, many investors try to sell bonds with lower interest rates. This forces those existing bond prices down to match the current market rates which are rising.
Bond Dynamics:
All bonds paying fixed interest rates are affected by this dynamic throughout their lives. Whether they are held all the way until maturity, which would normally be back to a “par value” of 100, or whether they are sold at some other time during their outstanding life. That price might be more than 100 when the bond is trading at a “premium” or less than 100 which is a “discount” to its initial issuing price.
However, just like on a see-saw, the farther out you sit from the center of the see-saw, the more volatility, the more up and down you can travel. In the bond markets, the longer the duration, the wilder the ride can be until the bond matures. In the fixed income markets, this volatility to interest rates is called duration risk. Using duration, you can estimate how much a bond’s price is likely to rise or fall if interest rates change. This can be thought of as a measurement of interest rate risk.
The longer the maturity of a bond, the higher the duration. A 30-year bond is going to have a higher duration risk than a 2-year bond. It’s therefore going to have more interest rate sensitivity than the shorter-term bond. Looking at the see-saw, duration would be the distance from the center point. The shorter the bond maturity, the lower its duration, the closer to the center point of the see-saw you sit, and therefore, the less up or down its price movement through maturity. Less stomach-turning price movement until the ride is over.
As you move out towards the end of the see-saw, as you move farther out the duration curve, you can be traveling farther up and down during the life of the bond. However, I have to remind you, all other things being equal, both bonds would ultimately travel back to the same resting place at their maturity. When the ride is over. When the contract is terminated at the bond’s maturity date. That is a Par value of 100, which is usually $1000 per bond.
Looking at 2022, here is an extreme case in duration risk. We’ve talked about this bond a few times the last 2 years. It’s the 100-year Austrian government bond issued back in 2017 with a repayment date of 2117. This is an AA+ rated country. This is not junk debt. When it was issued it was issued at 100 and yielded, .2.11%. Yes, 2.11% per year for 100 years. Don’t laugh, they did it again in 2020 and lent money to the Austrian government for another century for an interest rate of just 0.88%. Steve Mnuchin, Treasury Secretary under President Donald Trump, proposed the US do this same thing in 2019 and 2020 but alas, we didn’t.
As you can see, this bond is the EXTREME example of duration risk. As global central banks took interest rates negative with QE, quantitative easing in 2018 through 2020, this bond appreciated over 125% in price, to 225 In 3 years. Yes, it doubled in price. Since interest rates troughed almost 2 years ago, and since Central banks around the world have been raising rates the last year, the price of this bond has fallen over 70% from its peak price around 225.
It now trades at around 70 and yields about 2.75%. Meaning, you can buy it today at a discount to par value for around $70, and if you hold it until it expires, expect to receive about 2.75% return per year until 2117 when it matures back at 100. This is the most extreme example of interest rate risk I can find.
Why do I bring this up? Because 2022 has been a historically bad year for bonds and stocks at the same time. Bonds are traditionally the stabilizer for a 60/40 asset allocation between stocks and bonds. And in 2022 they have been anything but. When you open your brokerage accounts, it will be unlikely that you will see anything but red ink on them, including in your bond holdings. The only question will be how much?
Was your fixed income allocation stretching for extra yield by owning lower credit quality companies like junk bonds? The JNK, junk bond ETF is down around -16% year to date. Or did you stretch and buy longer maturity Treasury holdings in the 10-to-20-year duration category? If so, expect your bond portfolio losses in those type of funds to be down 25-30%. The TLT, Treasury bond ETF which mimics a 20-year Treasury bond, is down almost -32% year to date. That’s as much as the Nasdaq technology index. Even high-grade corporate bonds are down a lot. The LQD ETF which indexes to a 8 year plus investment grade corporate bond is down almost -22%.
Even the shorter duration 2–3-year fixed income portfolios have negative returns of between -2 and -7% depending on how aggressive your manager was. The good news there, is those yields will be adjusting higher over the next 12-18 months as older 2-year bonds bought in the 4th quarter of 2020 that were yielding 25-50bps mature, and bond managers replace them with new 2-year bonds yielding 4-4.35% right now. That is making them the best place in a bad bond neighborhood still.
Remember, Federal Reserve monetary policies and government fiscal policies work with a lag both on the way up and down. Looking out to 2023, particularly post 1st quarter, the economy is likely to be slowing with inflation albeit high, dropping fast. In that environment, with rates high and inflation dropping, it would be wise to be allocating more to a 60/40 portfolio, not bailing out of bonds.
Implications:
The impacts from recent Fed rate hikes are being quickly passed on to the bond markets much as they have the stock markets. Unfortunately, areas of the economy that the Fed is watching such as jobs and wages, have yet to feel the full impact of these aggressive rate hikes. They will. It’s only a matter of time. In the meantime, higher yields in bonds are making the asset class more attractive for the first time in years as their real yields, or what they yield over inflation expectations, are back to positive.
If the ongoing market volatility is making you feel uneasy, give us a call, and schedule a meeting with an Oak Harvest advisor. Our team does have insurance-based tools that do not have the volatility of public stock or bond markets. However, we remind you, that these investments may also have lower long-term expected returns.
Are you trying to meet your needs or your greed’s in retirement? Give us a call here and schedule an initial consultation with an Oak Harvest Advisor. We will sit down with you and help you and your family do the math to figure out if you will be able to meet your retirement goals and needs.
At Oak harvest, we think our clients are best served by us helping them plan for their future needs, instead of focusing on the past. The future is always uncertain and that’s why our advisors and retirement planning teams, plan for your retirement needs first, and your greed’s second.
Give us a call to speak to an advisor and let us help you craft a financial plan that helps you meet your retirement goals. Call us here at (877) 896-0040, and schedule an advisor consultation. We are here to help you on your financial journey into and through your retirement years.
– I’m Chris Perras and from everyone here at Oak Harvest Have a blessed weekend.
Chris Perras
CFA®, CLU®, ChFC®
Chief Investment Officer, Financial Advisor
Chris is a seasoned investment professional with over 25 years of experience working with some of the most successful money management firms in the world. Chris has made it a point in his career to adapt as the market landscape changes, seeking to utilize the appropriate investment strategy for a given market environment. His transition from managing billions of dollars at the institutional level to helping individuals and families retire is guided by a desire to see first-hand the impact he is making in the lives of clients at Oak Harvest.